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December 20, 2012

Who Will Be Subject to Obamacare Net Investment Tax?

While we are all hanging on the “fiscal cliff” and wondering what will happen in Congress, there are two new taxes that will definitely become effective Jan. 1.

Regardless of what comes of the fiscal cliff negotiations, a new Net Investment Income Tax goes into effect starting in 2013. The 3.8% tax applies to individuals and estates and trusts that have certain investment income above threshold amounts. It is part of President Barack Obama’s Affordable Care Act and Medicare overhaul. Also, a new Additional Medicare Tax goes into effect in 2013 as well. The 0.9% tax applies to an individual’s wages, Railroad Retirement Tax Act compensation and self-employment income that exceeds a threshold amount based on the individual’s filing status.

The IRS recently released proposed regulations concerning the two new taxes and how they will apply.

The Net Investment Tax

What is the net investment tax?

Individuals will owe the tax if they have “net investment income” and also have modified adjusted gross income over the following thresholds:

Filing Status

Threshold Amount

Married filing jointly

$250,000

Married filing separately

$125,000

Single

$200,000

Head of household (with qualifying person)

$200,000

Qualifying widow(er) with dependent child

$250,000

What is net investment income?

Net investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, nonqualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities. Net investment income is reduced by certain expenses properly allocable to the income.

Estates and trusts are subject to the tax if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount is $11,650).

The tax will not apply to any gain that is excluded from gross income for regular income tax purposes. For example, the first $250,000 ($500,000 for a married couple) of gain recognized on the sale of a principal residence is exempted from gross income for regular income tax purposes and, thus, from the net investment tax as well.

Investment expenses, such as investment advisory and brokerage fees, expenses related to rental and royalty income and state and local income taxes may be deductible in arriving at net investment income.

For individuals, the tax will be reported on, and paid with, Form 1040. For estates and trusts, the tax will be reported on, and paid with, Form 1041.

The Additional Medicare Tax

The tax applies to wages and compensation above a threshold amount that are received after Dec. 31, 2012, and to self-employment income above a threshold amount received in taxable years beginning after Dec. 31, 2012. The tax will be levied at 0.9%.

Filing Status

Threshold Amount

Married filing jointly

$250,000

Married filing separately

$125,000

Single

$200,000

Head of household (with qualifying person)

$200,000

Qualifying widow(er) with dependent child

$200,000

All wages that are currently subject to the Medicare tax are subject to the tax if they are paid in excess of the applicable threshold for an individual’s filing status.

Individuals liable for the tax will calculate their additional Medicare tax liability on their individual income tax returns (Form 1040). Individuals will also report the tax withheld by their employers on their individual tax returns. Any amount of tax withheld by an employer will be applied against all taxes shown on an individual’s income tax return, including any additional Medicare tax liability.

How Are Employers Affected?

Employers must withhold the tax on wages paid to employees in excess of $200,000 in a calendar year, beginning Jan. 1, 2013. An employer has this withholding obligation even though an employee may not be liable for the tax because, for example, the employee’s wages together with that of his or her spouse do not exceed the $250,000 threshold for joint return filers. Any withheld tax will be credited against the total tax liability shown on the individual’s income tax return (Form 1040).

An employer that does not deduct and withhold the tax as required is liable for the tax, unless the tax that it failed to withhold from the employee’s wages is paid by the employee. Even if not liable for the tax, an employer that does not meet its withholding, deposit, reporting, and payment responsibilities may be subject to all applicable penalties. There is no requirement that an employer notify employees about the tax.

The new proposed regulations concerning both taxes may or may not shed much light on them. Their implementation in 2013 will also provide guidance. However, it is clear that 2012 is the last year to which these taxes will notapply. Consider taking capital gains now, before any new taxes kick in, and take advantage of 2012’s lower rates as well. The best time to plan, as always, is sooner, rather than later.

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